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Th math behind expected utility theory.

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x is a random variable with realizations x1 and x2, x1 < x2. u is the utility function. u is increasing and strictly concave. p = prob{x = x1}, 1 p = prob{x = x2} Model Setup

x is a random variable with realizations x1 and x2, x1 < x2. u is the utility function. u is increasing and strictly concave. p = prob{x = x1}, 1 p = prob{x = x2} Model Setup

x is a random variable with realizations x1 and x2, x1 < x2. u is the utility function. u is increasing and strictly concave. p = prob{x = x1}, 1 p = prob{x = x2} Model Setup

Jensens Inequality Derivation for the two-point support case

Jensens Inequality Derivation for the two-point support case

Jensens Inequality Derivation for the two-point support case

Looking at it Graphically

Larger D: Base = x2 - x1 Height = u(x2) u(x1). Smaller D: Base = E(x) - x1 Height = ? E(x) - x1 = px1 + (1 p)x2 x1 = (1 p)(x2 x1).

Larger D: Base = x2 - x1 Height = u(x2) u(x1). Smaller D: Base = (1 p)(x2 x1). Smaller D: Height = (1 p)[u(x2) u(x1)].

Conclusion

More Algebra

More Algebra

More Algebra

Justification of Labeling

Constant Absolute Risk Aversion Constant Relative Risk Aversion Quadratic Utility

Constant Absolute Risk Aversion Constant Relative Risk Aversion Quadratic Utility

Constant Absolute Risk Aversion Constant Relative Risk Aversion Quadratic Utility

u(x) = -ke-gx + c; k, g, and c constants; k, g > 0. u(x) = gke-gx > 0, u(x) = -g2ke-gx < 0. -u(x)/u(x) = g.

u(x) = -ke-gx + c; k, g, and c constants; k, g > 0. u(x) = gke-gx > 0, u(x) = -g2ke-gx < 0. -u(x)/u(x) = g.

u(x) = -ke-gx + c; k, g, and c constants; k, g > 0. u(x) = gke-gx > 0, u(x) = -g2ke-gx < 0. -u(x)/u(x) = g.

u(x) = kxa + c; k, a, and c constants; k > 0, 0 < a < 1. u(x) = akxa-1 > 0, u(x) = a(a-1)kxa-2 < 0. -xu(x)/u(x) = 1 - a.

u(x) = kxa + c; k, a, and c constants; k > 0, 0 < a < 1. u(x) = akxa-1 > 0, u(x) = a(a-1)kxa-2 < 0. -xu(x)/u(x) = 1 - a.

u(x) = kxa + c; k, a, and c constants; k > 0, 0 < a < 1. u(x) = akxa-1 > 0, u(x) = a(a-1)kxa-2 < 0. -xu(x)/u(x) = 1 - a.

u(x) = -ax2 + bx + c; a, b, and c constants; a, b > 0. u(x) = -2ax + b > 0 if x < b/2a, u(x) = -2a < 0. E(u(x)) = -aE(x2) + bm + c = -a(s2 + m2) + bm + c.

Quadratic Utility

u(x) = -ax2 + bx + c; a, b, and c constants; a, b > 0. u(x) = -2ax + b > 0 if x < b/2a, u(x) = -2a < 0. E(u(x)) = -aE(x2) + bm + c = -a(s2 + m2) + bm + c.

Quadratic Utility

u(x) = -ax2 + bx + c; a, b, and c constants; a, b > 0. u(x) = -2ax + b > 0 if x < b/2a, u(x) = -2a < 0. E(u(x)) = -aE(x2) + bm + c = -a(s2 + m2) + bm + c.

Quadratic Utility

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